Best Liquid Funds To Invest In: Smart Choices

Liquid funds are a type of debt fund that invests in short-term, high-quality fixed-income instruments such as commercial papers, government securities, and treasury bills. These funds are suitable for investors who want to invest for a very short period, typically up to 91 days, and are looking for an alternative to bank accounts or deposits. Liquid funds offer high liquidity, low risk, and modest returns, making them a safe and convenient option for investors. When choosing a liquid fund to invest in, it is important to consider factors such as the fund's objectives, expected returns, investment horizon, and associated costs.

How liquid funds work

Liquid funds are a type of debt fund that provides investors with a high degree of liquidity and capital safety. They invest in short-term fixed-income generating money market instruments, such as treasury bills, commercial paper, and certificates of deposit. These funds aim to provide investors with a safe and convenient way to invest their short-term cash reserves, offering modest returns while preserving capital.

Here's how liquid funds work:

Where do Liquid Funds Invest?

Liquid funds typically invest in securities that are short-term, of good credit quality, and highly liquid. They focus on investing in listed commercial papers and are not permitted to invest in risky assets as defined by SEBI norms. These guidelines help to reinforce the fund's low-risk nature and contain credit risk. Additionally, liquid funds must hold at least 20% of their assets in liquid products, such as cash and money market securities. This ensures they can quickly meet redemption demands.

Sources of Earnings

The primary source of earnings for liquid funds is interest payments on their debt holdings. A small portion of their income is generated through capital gains. When interest rates fall, bond prices tend to rise, and vice versa. Liquid funds invest in short-term securities, so their market value doesn't fluctuate significantly with interest rate changes. As a result, liquid funds have low-interest rate risk and do not experience substantial capital gains or losses.

Advantages of Liquid Funds

Liquid funds offer several advantages to investors:

• Low Risk: Liquid funds are considered low-risk investments as they focus on preserving the principal amount and providing steady returns.
• Low Cost: These funds are not actively managed, resulting in lower expense ratios, typically below 1%. This maximizes the effective return for investors.
• Flexible Holding Period: Liquid funds offer flexible investment options, with no lock-in period. While a small exit load may be charged for early redemption, investors can still easily enter and exit the investment.
• Quick Redemption: Redemption requests are typically processed within one working day, and some funds even offer instant redemption.

Who Should Invest in Liquid Funds?

Liquid funds are well-suited for investors with a short investment horizon, typically up to 3 months. They are ideal for those who want to park their idle cash temporarily and generate modest returns. Liquid funds can also be used as a medium to route funds into other long-term investments. Additionally, they are a good option for investors who want to maintain contingency funds, as they provide liquidity, safety, and modest returns.

Things to Consider Before Investing in Liquid Funds

While liquid funds are considered low-risk, it's important to remember that they are not entirely risk-free. Here are some things to keep in mind:

• Returns are not guaranteed: Unlike bank deposits, liquid funds do not guarantee a fixed return. The returns depend on market interest rates, so investors should research the track record of the fund.
• Credit Risk: Liquid funds are not immune to credit risk. It's important to choose funds with high-quality portfolios to minimize this risk.
• Not for Wealth Creation: Liquid funds are designed for capital preservation and liquidity rather than significant wealth creation.
• Evaluate Returns and Expense Ratios: Compare the returns and expense ratios of different liquid funds to make an informed decision. A high expense ratio can significantly reduce the final net return.

Taxation on Liquid Funds

The taxation of liquid funds depends on the holding period:

• Short-Term Capital Gains: If the investment is redeemed within 3 years, short-term capital gains tax is applicable, and it is taxed according to the investor's income tax slab rate.
• Long-Term Capital Gains: If the investment is held for more than 3 years, long-term capital gains tax of 20% is levied, with the benefit of indexation to adjust for inflation.

Who should invest in liquid funds

Liquid funds are a type of debt mutual fund that invests in securities with a residual maturity of up to 91 days. They are considered a good option for investors who are looking for a short-term, low-risk investment option. Here are some scenarios where investing in liquid funds can be beneficial:

• Investors with a short investment horizon: Liquid funds are ideal for those with an investment horizon of up to 3 months, as the funds invest in securities with comparable maturities. If you are looking for a place to park your money for a few weeks or months, liquid funds can be a good option.
• Investors who want to keep contingency funds: Liquid funds offer high liquidity and safety while providing returns that are typically higher than those of fixed deposits. This makes them a good option for investors who want to keep an emergency fund that can be easily accessed when needed.
• Investors who invest in bank deposits: Those who keep their surplus funds in bank deposits can benefit from liquid funds in terms of both flexibility and returns. Bank fixed deposits often have lock-in periods and penalty charges for premature withdrawal, while liquid funds offer flexible holding periods and easy exit options. Additionally, liquid funds typically offer higher returns than savings accounts.
• Investors who need to park funds temporarily: Liquid funds are designed to keep funds safe while earning a small return. If you have received a large sum of money, such as a bonus, inheritance, or property sale proceeds, you can temporarily park it in a liquid fund until you decide on a long-term investment option.
• Investors looking to route investments into equity funds: Liquid funds can be used as a medium to route investments systematically into equity funds through a systematic transfer plan (STP). This allows investors to invest in equity periodically while earning stable returns on the corpus in the liquid fund.
• Investors seeking diversification: Adding liquid funds to an investment portfolio that primarily consists of equity funds can help to balance the risk. The low-risk nature of liquid funds can provide a hedge against the volatility often associated with equity investments.

It is important to note that liquid funds may not be suitable for long-term investment goals and typically generate lower returns compared to other mutual funds. However, they offer high liquidity, safety, and modest returns, making them a good option for short-term investment needs.

Advantages of liquid funds

Liquid funds are a type of debt fund that provides a high degree of liquidity and are considered safe compared to other mutual fund categories. They are ideal for investors who want to invest for a very short term and are looking for alternatives to bank accounts or deposits. Here are some advantages of liquid funds:

Higher Returns

Liquid funds can give higher returns than money kept in savings accounts or fixed deposits. They have been known to give up to 50% to 100% higher returns than a savings bank account. During high inflation, liquid funds are feasible investment instruments, allowing investors to earn a steady return of 7% to 7.5%.

Low Risk

Liquid funds are low-risk debt funds as most of their investment is in government securities. They invest in papers that mature in less than 91 days, and the risk associated with these funds is quite low. Longer maturity periods enhance credit rating fluctuations that will affect an investor's money.

High Liquidity

Liquid funds are highly liquid and have no lock-in period. This means that investors can withdraw their investment within 24 hours of the request. Liquid funds have exit loads of less than 7 days, so investors can easily redeem their investment within just 7 days without paying any penalty charge.

Low Expense Ratio

Liquid funds are managed by professionals, so fund houses charge management fees as part of the fund's expense ratio. Liquid mutual funds carry a very low expense ratio and hence they offer higher profitability.

Tax Benefits

Liquid funds have debt taxation, and the holding period stands at 3 years. After three years, when investors redeem, they enjoy the benefit of indexation as the profit is treated as a long-term capital gain. Liquid funds are taxed as short-term capital gains if held for less than 3 years and as long-term capital gains if held for more than 3 years.

Risks of liquid funds

Liquid funds are considered a safe investment option, but they do carry some risks. Here are some of the key risks associated with liquid funds:

Interest Rate Risk

While liquid funds have a low interest rate risk compared to other debt funds, they are still subject to changes in interest rates. When interest rates rise, the market value of the fund may suffer due to capital losses. However, since liquid funds invest in short-term securities, the impact of interest rate changes is limited.

Credit Risk

Liquid funds may invest in lower-rated bonds or commercial papers with poor credit quality. This increases the credit risk, as it may become difficult to find buyers for these securities if the fund needs to be liquidated. In the event of a default by the issuer, investors may lose their principal amount.

Inflation Risk

Liquid funds may not always provide returns that outpace inflation. In periods of low-interest rates, inflation can erode the returns on liquid funds, resulting in negative real returns.

Limited Scope

Liquid funds are designed for short-term investment goals and are not suitable for long-term investment plans. Investors seeking capital appreciation over the long term should consider other investment options.

Market Risk

Liquid funds are subject to market risks, and the Net Asset Value (NAV) of the fund can fluctuate. While the fluctuations may be less pronounced compared to other debt funds, there is still a possibility of capital loss.

Redemption Risk

Liquid funds offer high liquidity, and investors can usually redeem their investments within one working day. However, in rare cases, the fund may face challenges in meeting redemption requests if the underlying securities are illiquid or there is a sudden surge in redemption requests.

While liquid funds are considered relatively safe, it is important to remember that all investments carry some level of risk. Investors should carefully consider their investment objectives, time horizon, and risk tolerance before investing in liquid funds or any other financial instrument.

Tax on liquid funds

Liquid funds are debt funds that invest in short-term assets such as treasury bills, government securities, commercial paper, and money market instruments. They are considered low-risk investments with flexible holding periods and quick redemption. These funds are suitable for investors with a short investment horizon, typically up to 3 months, and those who want to park their funds temporarily.

Now, let's discuss the taxation aspect of liquid funds:

Taxation on Liquid Funds:

Liquid funds are taxed on dividends and capital gains. Dividends from liquid funds were tax-free for investors before the 2020-21 financial year. However, currently, investors need to pay tax on dividend income, which is taxed at the applicable income tax slab rate.

When it comes to capital gains, if an investor redeems the units of a liquid fund within three years of holding, it is considered a short-term capital gain. This gain is also taxed according to the investor's income tax slab rate. On the other hand, if the investor holds the liquid fund for more than three years and then redeems it, the gain is treated as a long-term capital gain. In this case, the investor benefits from indexation, where the purchase price is adjusted for inflation using a government-provided index. The long-term capital gains tax rate is currently 20% after indexation.

It's important to note that taxation laws can change over time, and investors should consult the latest guidelines and seek professional advice before making investment decisions.

Frequently asked questions